Review: The Investor’s Manifesto

Every Sunday, The Simple Dollar reviews a personal finance book or other book of interest.

The Four Pillars of Investing, an earlier book by William Bernstein, was one of my favorite books I’ve ever read on investment topics. It was intellectually challenging, offered great investment advice, and stuck to reasonably conservative investment plans – in other words, it did not tell you to put all of your money in stocks and/or real estate.

I wasn’t even aware that Bernstein had a new investment book out, but when I was scanning the personal finance shelves at my local bookstore, the vague tongue-in-cheekness of one book’s full title caught my attention: The Investor’s Mainfesto: Preparing for Prosperity, Armageddon, and Everything in Between. My immediate reaction was that someone else was tired of the constant onslaught of books predicting a financial apocalypse and that actual good financial planning involved preparing for a full range of potential long term outcomes.

When I saw that the author was William Bernstein, I was immediately intrigued.

Is it anywhere close to as worthwhile a read as the excellent The Four Pillars of Investing? Or does it just photocopy information available elsewhere? Let’s dig in and find out.

1 – A Brief History of Financial Time
Whenever you invest money, you’re investing it in one of two forms: loans (including bonds and savings accounts) and equity (partnership or ownership or stocks). In the eyes of the law, the former has more legal standing and importance than the latter, thus bonds and savings accounts will always have less risk than stocks or business partnerships. When a nation goes through a period of great political upheaval, both loans and equity can significantly drop in value and the possibility exists that neither will recover (though, as said before, loans have more legal protection).

This is essentially the reason why conservative investments are encouraged during periods of economic turmoil. When economic turmoil happens, the less protected positions (stocks) are often abandoned for the more protected positions (bonds, cash savings, etc.). During prosperity, the reverse happens – people move their money back into the less protected positions because the potential returns are much greater, especially in times of economic growth when companies and partnerships are making lots of money.

2 – The Nature of the Beast
You don’t know the day you’re going to need to cash in your portfolio. You also don’t know what’s going to happen next in the stock market or in the broader economy either. If it’s good news in the future, stocks and business partnerships will outgain bonds and other conservative investments. If it’s bad news in the future, bonds and other conservative investments will beat stocks and bonds handily.

The only way to prepare for the future, then, is to balance the two. “Expected returns” are mostly just best guesses, so your best bet is to simply design your portfolio to minimize the chances of you dying poor. Balance. Don’t time the market or focus on individual stock picks unless you have psychic abilities.

3 – The Nature of the Portfolio
Many people go way over the top when it comes to portfolios. It really doesn’t help to be overly complicated with your portfolio, because the fees and effort involved in making a complicated portfolio rarely add up to any sort of significant premium over a simple portfolio.

Bernstein suggests simply having a domestic total stock market fund, a foreign total stock market fund, and a bond fund as your entire portfolio. You can adjust the percentages as you like, but an equal split is fine, as is a 40 (bond)/30/30 split.

4 – The Enemy in the Mirror
Many people fall into the trap of oversimplifying the stock market, which is usually a mistake. There are many, many factors constantly at work in the stock market, from big institutional investors and human error to the general economy and the specific businesses within it. As humans, we tend to oversimplify stuff all the time in order to make the complicated comprehensible.

Your best move is, almost always, to just stick with large index funds. That way, you’re not trying to make bets on various companies or on various specific aspects of the stock market. You’re instead betting on capitalism as a whole and human ingenuity.

5 – Muggers and Worse
The more “complex” an investment product, the more laden with fees and expenses it likely is and the harder a salesman will try to sell it to you. Of course, such “complex” products often end in disaster, too (see 2008).

If you don’t understand an investment, don’t invest in it. For example, if you can’t explain how a derivative works, don’t buy it and don’t let any of your investment advisors do so, either. Stick with what you know, even if you’re missing out on some salesman-created glowing promise of outsized returns.

6 – Building Your Portfolio
It’s okay to lose money in stocks as long as everything is declining. What’s worrisome is when you’re losing money while the rest of the market is holding steady or growing. That’s the danger of not buying broadly – you’re trusting someone else’s judgment of a situation so complex that no one fully understands it.

Bernstein walks through various portfolios – some complex and some very simple – and talks about the ins and outs of each. To put it bluntly, the simple ones almost always win. Why? They’re not laden with extra fees and they just hold everything very broadly. The complex ones win on occasion, but the broad ones usually win over the long haul.

7 – The Name of the Game
The book closes with a very short chapter that essentially says that the real challenge for an individual investor is to decide the percentages. What percentage stocks? What percentage bonds? That’s really the question, because it sums up the true risk we’re willing to take on.

I am both a fan and a critic of Bernstein. Chapter Two of “Four Pillars” is the best chapter of any investing book I have ever read. I have re-read it four times. I always learn something new from doing so. I find that the advice in the other chapters of the book is often in conflict with the strong common-sense arguments made in Chapter Two. I find a good bit of that advice dangerous.

The root of his confusion (in my view!) is his believe that it is by taking on more risk that one earns higher returns. If that were so, stocks should have been paying the highest returns in history from 2000 forward because stocks were the riskiest they have ever been in 2000 (when valuations were the highest they have ever been). The reality is that it is perceived risk that signals high returns (perceived risk was the lowest it has even been at the top of the bubble — that’s why there was a bubble!). if Bernstein straightens out his thinking on this point, I think he will be one of the best in this field.

That’s an outstanding point. When Bernstein and other proponents of modern portfolio theory and efficient markets talk about the correlation between risk and return, they equate risk to the standard deviation expected returns, and ignore fundamental factors such as PE ratios.

The investing books that incorporate the knowledge from Behavioral Finance do a better job avoiding that mistake.

@Rob Bennett
Risk doesn’t *guarantee* a high return but it has a greater probability of a high return. Think a small cap stock vs. 30 year US treasury bond. One can possibly triple in price or go to zero, another will only earn a few % a year but will never go to zero.

Nobody knows the future and you might get burned in the short term (like the bubble we just had), but long term it makes sense for a younger person who can take on risk to have riskier investments in his portfolio.

There is no such thing as a sure signal for high returns; otherwise we would all be rich. I hope I am not misunderstanding you.

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